Why Utilities Have Underperformed the S&P Since 2008

Juicy dividend yields are available, but be careful in choosing

After five years of QE, including the suppression of long-term interest rates by the Federal Reserve, many utilities and telecoms now yield about 20% less than their five-year dividend yield averages. All numbers vary on a case by case basis, of course, but by now we can all agree that there was a premium on dividend yields brought on by QE and, naturally, we may see a discount as QE begins to wind down in 2014.

This is one of the reasons why the Utilities Select Sector SPDR (XLU) has underperformed the S&P 500 (INX), with that under-performance accelerating a bit in May of 2013, when the barbershop term “taper” first appeared in the vocabulary of outgoing Fed Chairman Bernanke. Utilities have shrunk to just 2.2% of the S&P 500 Index, which is one of the lowest weights for the sector that I remember seeing in a long-time.

During the bull market in bonds, which has been ongoing since 1981, there have been many periods in which long-term interest rates have backed up somewhat, pressuring the utility sector. Last year may turn out to be one of those “rising rates” years, which in the end turns out to be nothing more than a new buying opportunity for bonds. Still, we do not know if the bull market in bonds is over, as shrinking deficits and very low inflation suggest that bonds may stage a comeback at some point in 2014 or 2015.

In the meantime, there are plenty of utility stocks that have been beaten down badly, some justifiably so. Those interested in juicy dividends certainly have enough candidates to choose from, but be careful. As a rule of thumb, sometimes yields go up for bad reasons, not because the company hiked the dividend, but because the share price went lower due to an adverse development. In such situations investors have to be even more careful, as a dividend can be cut before the company has to resort to more drastic measures.

The Juiciest Ute Yields

Due to their recent falling out with investors, the Ute sector has once again seen yields rise above 5%. The top 10 highest yielding companies in the S&P 500 at the end of the third quarter include six utilities: Exelon (EXC, 6.2%), Entergy (ETR, 5.4%), TECO Energy (TE, 5.2%), Integrys Energy Group (TEG, 5.1%), PPL Corp. (PPL, 4.8%), and Consolidated Edison (ED, 4.4%). At the end of the fourth quarter, FirstEnergy (FE) attained an even higher dividend yield of 6.8% (which I may discuss at another time).

From this list, we see one S&P utility yielding above 6% and three yielding above 5%. As income investors are painfully aware, 6% yields are very rare in the utility space, while 5% yields are rare, so one naturally needs to investigate: What happened and – more importantly – are these yields sustainable?

Prior to the crisis of 2008, EXC was outperforming the utility sector, as represented by the Utility Select Sector SPDR (XLU), while in the five years since the crisis EXC has been underperforming badly. With all the help from QE and the Fed, which has generally boosted most other utilities, what gives with EXC?

Keep in mind that EXC yields 6.2% after it cut its quarterly dividend from 52.5 cents to the present rate of 31 cents. A rate cut is generally not favorably viewed by investors, as they tend to buy utility stocks for their safety. EXC is the operator of the largest nuclear fleet, compared to any other U.S. utility, which gave it a competitive advantage in the five years leading up to 2008, due to rising fossil fuel prices back then.

Nuclear is the type of electric power generation with the most stable costs. This is because the highest nuclear power generation costs are for reactors. The nuclear fuel is, up to a point, a relatively small variable cost. All this was great news before the shale boom, when natural gas prices were rising—natural gas is also a popular fuel for electric power plants—but after the shale boom the high fixed cost of nuclear power has turned from a competitive advantage into a competitive disadvantage. In other words, the fundamentals that used to propel EXC higher, before 2008, are pulling it lower now.

Exelon has other sources of generation, like wind, and it is working to address all those issues that gave natural gas-burning utilities an advantage. With an 88% payout, its dividend is not super safe, but management is trying to realize the cost savings from a recent merger to improve the health of its balance sheet.

There is serious political pressure to curb greenhouse gases. Coal is the dirtiest way to generate electricity, but it is also the most popular. Hydro is great but there is not enough. There are better things we can do with natural gas than make electrical power – like drive our cars, fuel our trucks and power public transportation. Nuclear can be as green as hydro, but the recent Japanese experience, brought on by a major quake and a tsunami, has probably set nuclear back, even though it provides a cheap and clean source of energy. I believe nuclear has staying power but it remains to be seen whether Exelon will continue to generate the kind of revenues needed to preserve the dividend.